As the year draws to a close, many investors and financial planners turn their attention to tax strategies that could help maximize after-tax returns. One of the most effective yet often underutilized strategies is “tax loss harvesting.”
This technique allows investors to turn a loss into an opportunity, potentially reducing their tax liability and positioning their portfolio for long-term success. Here’s how it works, why it’s beneficial, and what you need to know to make the most of it.
What is Tax Loss Harvesting?
Tax loss harvesting is a strategy that involves selling investments at a loss to offset gains from other investments. By “harvesting” these losses, investors can reduce the taxable capital gains in their portfolio, which ultimately lowers their tax bill for the year. If capital losses exceed capital gains, up to $3,000 of the net capital loss can be used to reduce other types of income, such as wages. Any remaining losses can be carried forward to future tax years.
Why Consider Tax Loss Harvesting?
For high-net-worth individuals or those with large, diversified portfolios, tax loss harvesting can lead to substantial tax savings. This is especially valuable for those with short-term capital gains, which are taxed at higher rates than long-term capital gains. Tax loss harvesting can be beneficial in almost any state, regardless of local income tax laws, as the primary savings come at the federal level.
Key Benefits of Tax Loss Harvesting
- Lower Tax Bill: Tax loss harvesting can directly lower the taxes an investor owes, especially for those in higher income brackets. This is achieved by offsetting both capital gains and ordinary income up to the IRS limit of $3,000 annually.
- Portfolio Rebalancing: Selling off underperforming assets allows investors to realign their portfolios with their financial goals. This provides an opportunity to review asset allocation and make adjustments that may otherwise be overlooked.
- Long-Term Compounding Benefits: By reinvesting the tax savings back into the portfolio, investors can potentially increase the portfolio’s long-term growth. These compounding effects can have a significant impact over time, especially for those with decades of investing ahead.
The Process of Tax Loss Harvesting
Tax loss harvesting typically involves several key steps:
- Identify Underperforming Assets: The first step is to review the portfolio for assets that have declined in value. Financial planners can assist clients in determining which losses could offset gains or be applied against ordinary income.
- Sell the Investment to Harvest the Loss: Once underperforming assets are identified, the next step is to sell the investment, realizing the capital loss. This loss can then be applied to offset other gains.
- Reinvest the Proceeds Carefully: A common strategy is to reinvest the proceeds into a similar asset to maintain the portfolio’s diversification and risk profile. However, be mindful of the “wash sale rule”, which disallows the tax loss if the investor repurchases the same or a “substantially identical” investment within 30 days before or after the sale.
Wash Sale Rule: A Common Pitfall
The wash sale rule is one of the most critical considerations in tax loss harvesting. This rule states that if an investor buys a “substantially identical” security within 30 days before or after the sale of the investment they harvested for a loss, the IRS disallows the loss for tax purposes.
To avoid a wash sale, investors can:
- Wait 31 days before repurchasing the same investment, or
- Invest in a similar but not identical security (for example, selling one S&P 500 ETF and buying a different S&P 500 ETF from another provider).
Tax Loss Harvesting with Life Insurance and Retirement Accounts
While tax loss harvesting is typically associated with taxable investment accounts, it’s worth mentioning the potential tax strategies involving life insurance and retirement accounts. For instance, life insurance products can provide tax-deferred growth and even tax-free distributions in certain cases. Combining a tax loss harvesting strategy with a permanent life insurance policy can be beneficial for high-net-worth investors seeking tax efficiency across all areas of their financial plan.
Additionally, though retirement accounts like IRAs and 401(k)s aren’t subject to capital gains taxes, investors can still benefit from tax-efficient strategies within these accounts. By holding tax-inefficient investments, such as bond funds, in tax-advantaged accounts, and utilizing tax loss harvesting in taxable accounts, investors can maximize their after-tax returns.
Best Practices and Timing
The end of the calendar year is an ideal time to evaluate tax loss harvesting opportunities, as investors have a clear picture of their total gains and losses. However, it’s often beneficial to monitor investments regularly and harvest losses throughout the year, especially during market downturns.
Coordinating with a financial advisor who understands both federal and state tax implications can make a big difference. An advisor can ensure proper compliance with IRS rules, such as the wash sale rule, while helping investors optimize their portfolio.
Is Tax Loss Harvesting Right for You?
Tax loss harvesting isn’t suitable for every investor. It generally works best for those in higher tax brackets who have a diversified portfolio and assets that have appreciated in value. The benefits might be less significant for lower-income investors or those with relatively small taxable portfolios.
Here are some questions to help determine if tax loss harvesting might benefit you:
- Do you have large capital gains this year?
- Are you in a higher tax bracket?
- Do you own underperforming assets that you’d like to sell?
For investors, tax loss harvesting can be a powerful tool in a comprehensive financial plan. By working with a financial planner or advisor who understands the complexities of this strategy, investors can unlock the potential to save on taxes and reinvest in their long-term goals.
Final Thoughts
Tax loss harvesting offers a unique way to manage investments proactively, turning market downturns into opportunities for tax savings and portfolio rebalancing. The benefits can be substantial, especially when considering both federal and state tax implications. If you’re curious about how tax loss harvesting could enhance your financial plan, consider consulting with a financial planner who specializes in tax-efficient investing.
This strategy, combined with other tax-saving approaches like life insurance, can provide a significant boost to your overall financial plan. In the world of financial planning, it’s not just about making money – it’s about keeping as much of it as possible, and tax loss harvesting is one way to do just that.
